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Tuesday, December 9, 2008

Buffett on "Cigar-Butt" Investing

In the Essays of Warren Buffett, Warren describes some of his past investing mistakes. He notes that his first mistake was buying control of Berkshire, which at the time was involved primarily in the difficult textile manufacturing business. Warren admits that he bought the company simply because it looked cheap which was a mistake.

Buffett describes the cigar-butt style of investing as buying a company at a sufficiently low price and then waiting for a favorable "hiccup" in the companies fortunes that creates an opportunity to sell the stock at a profit. The comparison to a cigar-butt is made because the company in question usually has "one puff of smoke left". Buffett writes that "unless you are a liquidator, that kind of approach to buying businesses is foolish".

Buffett goes on to say that he had to learn the hard way, several times, to understand the principle that "time is the friend of a good business but the enemy of a mediocre business". He provides a clear example on this lesson with Hochschild, a department store company. Buffett bought the company at a large discount to book value and the deal included some hidden real estate value and a large LIFO inventory cushion. At the time Warren felt confident on the purchase, but three years later he felt fortunate to be able to exit the investment at a break-even.

Buffett comments that over 25 years, he has learned that it's best to avoid difficult business problems and not to try to solve them.